Option ARMs: A Negative 'Option' Explained (Pay Option ARMs)

Are you tempted by the siren song of low, low monthly payments? Do you get eye strain from trying to read the fine print flying by on the screen, only to be confused as to what it says? You're not alone. There are many thousands of people just like you, many of whom who already have selected a loan which not only allows for but guarantees rising loan balances and monthly payments in the years ahead.

This article will help you understand the pervasive effects of negative amortization, and may help you to decide whether a "minimum payment" mortgage is to your maximum benefit.

What is an Option ARM or Pay Option ARM? Simply, it's a mortgage loan which allows you a choice of payment methods: fully amortizing over 30 years, fully amortizing over 15 years, interest-only payments, or a payment based on a below-market "payment rate" which fails to cover even the interest which is due. In such an arrangement, the differential between what you actually owe and what you are paying is added onto the outstanding loan balance each month, a condition known as "negative amortization."

A negative amortization mortgage isn't something that most people would ask for by name, but they can be attracted to ultra-cheap monthly payments. Call them what you will -- "Option ARM", "PayOption ARM", "Pick-a-Payment", "Cash-flow ARM", or other descriptive term -- one thing is certain: these products all feature a payment method where the interest you pay is based on an artificially low contrived interest rate based not on market conditions, but on nothing more than a lender's marketing ability.

A Little History

Loans which allow for negative amortization aren't new; they date back to mid-1980s, when fixed rate mortgages were in the uncomfortably high 9%-10% range. ARMs based upon the 11th District Cost of Funds Index, or COFI ("coffee" ARMs) were available at comparably attractive initial rates around 7%, and featured new and novel ideas like annual "payment caps" instead of per-adjustment interest rate limits each year. In fact, payment caps were actually a selling point at the time, when interest rates were considerably more volatile than today: payment caps promised some budgetary peace of mind because no matter what happened to rates, your required payment would rise only a little from year to year.

ARMs in general were still fairly new on the scene and not well understood. Many borrowers found out too late that, unlike rate-capped ARMs (where any charges due to interest rate changes in excess of two percentage points were absorbed by the lender), pay-capped ARMs took the difference between what you were paying and what you actually should have been paying, and added it back onto the loan balance. Worse yet, borrowers took these ARMs just before a considerable rise in the COFI which took that index from the low 7% range to nearly 9%. After margins were added, the interest rates on those loans -- which started in the sixes -- climbed to around 11%.

Between an ever-rising loan balance and what seemed to be ever-rising interest rates, many borrowers found themselves in trouble. That was even before property prices in many areas began to fall, leaving more than a few borrowers with negative equity: their loan balance was higher than the home's resale value. These 'underwater' borrowers found that selling their homes still left them with a sometimes sizable debt.

Today's Differences

Unlike those 1980s experiences, where those loans inadvertently became negatively-amortizing due largely to market conditions, today's loans have a different twist: They begin in a neg-am situation, where a rising loan balance is guaranteed. Rather than the interest rate starting at market rates and perhaps rising over time (while the borrower has opted to make only a limited payment), these products come out of the box with a "payment interest rate" well below what is actually being charged. As a result, the loan balance starts to increase right away. This chart shows how the gap between the interest rate you are being charged and the interest rate you are paying starts pretty wide, but has then gotten wider over time.

About the Accompanying Charts

For these charts, we made what we think are realistic assumptions. First, we started with a one-month LIBOR-based option-style ARM in June 2003 with a minimum payment rate of 1.5%. Then, we followed the actual trajectory of interest rates from 2003 to May 2005. From there, we assumed that LIBOR (like other short-term interest rates) would rise a total of 0.75% over the next 12 months, then level off and hold steady for the next year after that. Most likely, the change to underlying interest rates won't be quite as smooth; the increase may be more or less than 0.75% over the next year, or rates may not hold steady after that. However, it's useful to know that over the last ten years, the average for the one-month LIBOR has been 4.119%, and our example never even gets as high as "average".

August 2006 Update:As it turns out, our working estimate from May 2005 was far below the actual trajectory for interest rates. In the original article, the highest actual index rate we used was 3.1126%, and we figured that LIBOR would climb up to 3.8626% over the next year. However, by the August 2006 update, LIBOR stood at 5.4045%, with our loan's interest rate well into the mid 7% range. The excess increase in rates means that negative amortization rose more quickly and over a longer period, and the mortgage holder would now have almost no equity leftover after the home is sold. The charts now show our original estimates and the updates. Go to the charts

Even though these loans are intended to be easy on the monthly budget, the guaranteedsteady 7.5% increase in your required payment each year will also begin to crimp your flexibility over time. If you're considering using one of these payment methods, you'll need to be aware that the initially-low monthly payment won't last, and that you will have to plan for higher payments accordingly.

You should also be aware that starting with a big gap in the payment stream produces a loan balance which grows more quickly than one which starts with an almost-fully-amortizing interest rate. That payment differential will grow as long as the loan balance continues to increase, exacerbated by increases in interest rates, demonstrated here. As well, that payment gap is only temporarily narrowed by the annual increases of 7.5% in the required payment amount, then continues to press upward as the loan balance and interest rate grows.

Rates steady, Due Payments Rising?

Unless the rate of interest at which you are making payments quickly approaches the rate you are being charged, it's a certainty that the monthly payments you actually owe will rise, even if the actual interest rate you are being charged doesn't. The reason is due to your ever-increasing loan balance, which requires a higher monthly payment (if only slightly) to cover the interest and principle which is actually due. In fact, our chart shows this fairly clearly; despite the "actual interest rate" holding steady during the final 17 months of the chart, the actual payment due continues to creep higher, rising by a total of over $30 per month during that time. Due to this, even if the your "actual interest rate" should decline somewhat, your "actual due payment" payment may not decline, but simply flatten out over time.

Protection and "Recast Triggers"

While these monthly neg-am ARMs do have some limits on how high your interest rate (and subsequent required payment) can rise, those ceilings are typically in the 9% - 10% range. If you've become accustomed to making payments well below that, you could find financial trouble when your rate gets recast.

Early neg-am ARMs typically had just one recast trigger, where your monthly payment was adjusted from the limited payment to one which was fully-amortizing. That normally occurred when the loan balance climbed, through negative amortization, to 115% or even 120% of the original loan amount. Even with rising rates and rising loan balances, it could take a long time to get to those triggers, but letting a deferment in payment build into potential catastrophic increase over a period of years (only to find that the borrower couldn't manage it) wasn't a prudent lending strategy. This time around, though, lenders have developed a slightly different strategy which provides them a little more protection.

A secondary, regularly-scheduled recast of your monthly payment is one of the newer wrinkles found in some of today's neg-am ARMs. At a set interval, usually five years, the lender will adjust your monthly payment to be fully reflective of the remaining balance at today's market interest rate. This could cause a measurable increase in your monthly payment, so you need to be prepared for it. As well, the old 120% or 115% triggers have been lowered, with many contracts allowing for "only" a 110% recast trigger.

Hitting a Trigger

It's considerably easier to hit a 110% trigger than a 120% trigger, but coupled with a 5-year recast it's safe to say that your payment will be rising fairly soon, regardless of the way you hit a given trigger. In fact, our example chart, using our assumptions, puts your outstanding loan balance at the 110% trigger at about the 51st payment -- just over four years down the road. Should that happen, your monthly payment will rise from its "limited" $460.90 per month to $710.26 per month -- a $250 per month kicker (with an original $100,000 loan amount) -- and that 54% increase in your monthly payment might be difficult for you to manage.

The Equity Gap

Of course, the risks of negative amortization isn't simply that your loan balance increases over time, or that you could face staggering rises in your monthly payment. There can be additional risks, especially when property prices fail to increase or increase only slightly over time (admittedly not today's problem, but no one really knows what market conditions lie ahead in the next few years). In such a situation, the property's value may increase only slightly over time, while your loan balance is increasing, too. This means that you aren't building much -- if any -- equity, which could be an issue should you want to sell your home (or refinance) down the road.

This is true even if you made a downpayment. If, for example, you bought a home for $105,263 and made a 5% downpayment, your loan amount would be the $100,000 found in our example. If property prices should increase at about the inflation rate expected over the next four years -- a 3% annual increase -- the value of the home would end up at $118,474 after four years. Now, typical sales commissions for residential real estate are about 6% of the selling price, which would subtract $7,108 from that gross total, leaving you with $111,366 after the disposition of your home. However, since your loan balance has increased over that time, the payoff of your loan (excluding any prepayment penalties) is $111,103 -- leaving you with a grand total of $263 in "profit" after four years (not to mention the costs of maintenance during that time). See this chart for a graphic description.

It's not certain that property prices will increase or decrease over the next few years (or by how much). One thing is certain, though -- your loan balance will have increased. A lower rate of property price appreciation, no property price appreciation or a downward adjustment in prices could leave you in a "negative equity" situation pretty quickly, meaning that, if you still want or need to sell, you'll need to cover some of those costs out-of-pocket.

The same caution goes is you should hope to refinance, as well. If property price appreciation doesn't "go your way" over the next few years, you may have little equity in your home, and could find it more difficult to refinance at terms favorable enough to be valuable to you.

While there's nothing specifically wrong with accepting a loan which allows for negative amortization, they aren't for everyone. Borrowers without 'liquid' asset strength -- cash reserves which can be tapped as needed, especially when a recast occurs -- may find themselves in a serious bind, so if you don't have ample reserves at your disposal, you should use caution when considering a neg-am product.

We realize that at least some investor/speculator borrowers are using these products because they prefer a low monthly mortgage carry cost, and hope to sell before the rising cost of the debt and sales charges overwhelm the rising value of the property. For some, this strategy has probably worked well, at least over the past few years, when home values have leapt by 10% or more each year. However, we cannot stress enough that "past returns are a poor indicator of future gains", and by no means is equity growth a certainty... although a rising loan balance is.

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